I invest for one reason. It's not a particularly altruistic reason, but I've found it surprisingly motivating.
I want to be rich.
Fortunately, although this goal may sound challenging, I learned at a young age the key to getting rich. It's as simple as taking advantage of what Einstein called "the most powerful force in the universe."
Here's how it works. Every month, invest a certain amount of cash in great companies. Wait for a few decades. Count your cash. How much money you make will vary, but it almost always ends up in a large total. Consider the following table.
| Monthly Investment | Annual Return | Years | Total |
|---|---|---|---|
| $200 | 12% | 35 | $1.16 million |
| $200 | 15% | 35 | $2.43 million |
| $500 | 10% | 30 | $1.08 million |
| $500 | 15% | 30 | $3 million |
| $500 | 15% | 35 | $6.08 million |
The details
There are several interesting details about the numbers, once you look beyond the humungous totals. First, note that time is really important. In the last two rows, investing for 35 years at 15% annual returns makes you nearly $3 million more than you'd get from investing for only 30 years. To get rich, start early.
Second, observe that the interest rate is extremely important. The only difference between the first two rows is the interest rate. A mere three-percentage-point annual difference in returns yields a difference of $1.27 million after 35 years. Every little percentage return really counts.
Another way of looking at this percentage-point difference is to think about your costs. If you were making 15% annual returns, but losing three percentage points each year -- 20% of your annual return -- to commissions and taxes, that could cost you $1.27 million after 35 years. If you really want to get rich, try to minimize such expenses by trading infrequently and holding for the long term.
Finally, it's noteworthy that compounding works because of the larger amount of money working for you with each successive year. If you lose money in a risky stock, you're not just hurting your returns this year, but also losing all of the cash that you would have made over the next 30 years. A single loss can cost you hundreds of thousands of dollars 30 years in the future.
Buying speculative stocks that go nowhere is nearly as bad. Investors in Elan (NYSE:ELN) and Micron Technology (NYSE:MU) have experienced some volatile times for the last decade, but they would have basically just broken even if they had held for that whole time. A 0% return might not seem so terrible, but remember how important time is for compounded returns. Ten years of investment time was essentially wasted.
Three criteria
These implications of compounding suggest that investors should look for investments that are:
- Likely to achieve above-average returns.
- Unlikely to lose capital.
- Solid enough to be held for years to minimize costs.
Consequently, the undervalued shares of exceptional companies are one of the best possible investments you can make.
Because exceptional companies have the staying power to both survive and grow for decades, you can hold them for years to let your money compound. Look at the long-term success of IBM (NYSE:IBM) and McDonald's (NYSE:MCD). Both companies are exceedingly strong. They've prospered through multiple business cycles and overcome major industry-specific challenges -- the rise of the generic PC and commoditization of computer hardware for IBM, and the burger wars for McDonald's.
You want to pick up these exceptional companies when they're undervalued, because that's when they're both the least likely to lose money and the most likely to have exceptional returns. Wells Fargo (NYSE:WFC), Citigroup (NYSE:C), and Bank of America (NYSE:BAC), for example, have achieved dramatic returns since the early '90s, not just because they are great businesses, but also because they were undervalued in the fallout from the savings-and-loan crisis of the late '80s.
Investing success
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Fool contributor Richard Gibbons thinks procrastination is actually the most powerful force in the universe. He does not have a position in any of the companies discussed in this article. Bank of America is a Motley Fool Income Investor pick. The Motley Fool has a disclosure policy.
